Analysis: Why the stock market is selling off, explained

Specialist Anthony Matesic, left, and trader Gordon Charlop work on the floor of the New York Stock Exchange, Monday, Feb. 5, 2018.(AP Photo/Richard Drew)

Heather LongThe Washington Post

The stock market is having a panic attack. The Dow is down almost 1,800 points (7 percent) in two days. Global markets fell sharply on Tuesday. CNBC has already dubbed it "selling hell."

So what is going on? And how much should you worry? Let's unpack what you need to know if you are someone who invests in stocks and bonds for the long-term and mostly tries to forget about the daily turbulence.

Wall Street was overdue for a "reality check."

The Dow was up over 26 percent from January 2017 to January 2018. That's a massive jump in one year. Historically, the stock market has gained 8 percent, on average, in a year. We just experienced three times that amount. Investors were beginning to look around and question whether stocks really should be at such high levels.

It's not a true correction yet.

For all the alarming headlines, this isn't a true correction yet. A correction is defined as a 10 percent drop from the prior market peak. On Wall Street, it's the equivalent of giving someone a time out. It may seem hard to remember now, but the Dow was sitting at an all-time high on January 26, just over a week ago. At the moment, the Dow is down 8.5 percent from that record level. So it's close to a correction, but not there yet. (The S & P 500 is down about 7 percent from its prior record level).

Ed Yardeni, a longtime stock market analyst, points out that the current bull market has been going since March 2009. In all these years, we've had four official corrections, so not many, but we have also had 60 "panic attacks," as Yardeni likes to call them. Those are periods where the market dipped and people predicted the worst, but we didn't even end up in a true correction.

"You can't make too much out of a couple of days of craziness," says Ed Yardeni, president of Yardeni Research. "I believe this, too, shall pass."

The "real economy" is doing well.

This dip in the markets does not mean another big recession is coming. In reality, the U.S. economy is doing very well right now. Unemployment is at a 17-year low, hiring is strong and growth is very solid (and expected to pick up more this year). Consumers and companies are opening their wallets and spending, and all indicators are that will keep happening in 2018.

It's worth repeating: The stock market is NOT the economy. The market downturn isn't being driven by bad economic news. If anything, it's been driven by too much good news.

The sell-off started because of the Friday "jobs report."

On Friday, the Labor Department put out its monthly report on how many jobs were created in January in the United States and how fast wages are growing. Overall, it looked like good news. The economy added 200,000 jobs and wages grew by 2.9 percent, the most since 2009. But Wall Street looks at things differently from most people. When companies pay workers more, it usually means lower profits for shareholders.

"As jarring as the correction has been, the stock market is not the economy," says Diane Swonk, chief economist at Grant Thornton. "It's good news that wages are going up."

Wall Street is REALLY worried about inflation.

It's not just higher wages that scare investors. It's also the prospect of more inflation. On a basic level, inflation is the rise in prices of everything from rent to groceries to gas to college tuition. A little inflation is a good thing because it usually coincides with a healthy, growing economy. But too much inflation is dangerous. It causes people to lose faith in the value of money. In extreme examples like Zimbabwe and Venezuela, a currency becomes essentially meaningless and the economy collapses.

No one is worried about that kind of inflation in the U.S. At the moment, inflation is very tame at just 1.7 percent. But the wage data on Friday spooked investors into thinking that inflation could rise quickly this year as the tax cuts take effect and more and more companies start raising pay and prices.

In short, Wall Street is freaking out about what could happen in 10 to 18 months, not right now.

Watch the Federal Reserve. Will it mess up?

Investors fear that the Federal Reserve is going to fumble its attempts to keep inflation in check.

Almost every major recession in modern U.S. history has been caused, at least in part, by the Federal Reserve. It usually plays out like this: The economy starts to grow faster than expected, wages and inflation shoot up, and then the Fed reacts by aggressively raising interest rates. This leads businesses and consumers to close their wallets, and the economy to tank.

At the moment, interest rates are incredibly low: Just 1.25 to 1.5 percent. But the Fed has indicated it intends to raise rates three times this year, so rates would end the year at 2.25 percent.

Now investors are worried that inflation might pick up even faster, forcing the Fed to raise rates to 2.5 or even 3 percent this year.

"This is a reality check that the market was price to a perfection that didn't exist," says Swonk.

There's a new leader at the Fed: Jerome Powell.

Compounding all of these worries is there is a new leader at the Federal Reserve. Economist Janet Yellen's last day was Friday. The markets loved Yellen because she kept interest rates low and she was slow to raise them. But Powell, a lawyer, is untested. Most think he'll be similar to Yellen, but no one knows for sure yet. He just started in the top job.

The bottom line is: The economy is doing well but stocks might not race up from here.

To sum up, the stock market dip looks like an overdue reality check on how high prices were on Wall Street. That's healthy.

The U.S. economy also still looks in good shape. Yes, there are concerns about inflation, but they have yet to materialize.

The big take-away for most people who have a 401(k) or a bit of money in the market is that we have just experienced almost unprecedented calm in the markets. Now things are likely to get more choppy. That's normal in historical terms, but we just haven't seen it in awhile, so it feels odd.

On top of that, with stock prices already so high (even after this sell-off, they're still high by historical standards), returns going forward might not be as great as what we've experienced the past few years. That doesn't mean it's a calamity, it just means we may be returning to more normal times. We all need to adjust our expectations: On the upside, we'll hopefully see higher wages for many Americans. On the downside, stock prices probably won't be as insanely good.

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